Trump's European baptism of fire

Italy is a problem for the US too

by Desmond Lachman in Washington

Tue 6 Dec 2016

It would be tempting for Donald Trump’s incoming administration to dismiss Prime Minister Matteo Renzi’s resounding defeat in Sunday’s constitutional referendum as an inconsequential vote on a distant shore. This would be a big mistake. The Italian crisis is a problem for the US as well as Europe.

Italy is a large economy of systemic importance. Its poor fundamentals make it ill-prepared to weather prolonged political instability. Italy has the potential to roil financial markets and derail the global economic recovery.

Italy is the euro area’s third-largest member country, with a $4tn banking system. It is the world’s third-largest government bond market, with issuance exceeding $2.5tn. Italy’s economic well-being is essential for the euro’s long-term survival, but it is too big for Europe to save in the event of a full-blown crisis.

Before the referendum, money flew the country as Italians fretted about the stability of their banking system, with non-performing loans totalling as much as 18% of banks’ balance sheets. European Central Bank data on Italy’s intra-euro area Target-2 balances suggest that Italian capital flight has been comparable to that at the height of the debt crisis in the first part of 2012.

Renzi’s resignation, tendered on Monday, is unlikely to prompt early elections. But Italy will probably be run by a government possessing little authority, given the overwhelming margin won by the No vote. An ‘institutional’ government would put wind in the sails of the opposition Five Star Movement, which says it wishes to take Italy out of the euro.

A weak government and an unreformed Senate that may continue to block legislation is not helpful to an economy as sclerotic and indebted as Italy’s. Without a strong government, there is little prospect for the type of reform that could allow the Italian economy to grow out of its public debt and banking sector problems.

If the country lurches towards an economic and financial crisis over the coming months, this will happen at an inopportune time for its major economic partners. France will hold presidential elections in April and May. Germany’s federal elections are expected in September. This will make it very difficult for Paris and Berlin to offer adequate support to Italy should a genuine upset arise.

Trump looks likely to face a European baptism of fire. I hope he will have the flexibility to adapt his economic programme to the new realities. Trump should tone down his confrontational rhetoric and provide the sort of leadership that might limit the fallout from an Italian crisis. If he does not do so, markets in the US and Europe should brace themselves for a rough ride.

Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and Chief Emerging Market Economic Strategist at Salomon Smith Barney.